Have you ever wondered why your payslip shows deductions before you even see the money? That is PAYE in action. Pay As You Earn is the statutory framework HM Revenue & Customs uses to collect Income Tax and National Insurance contributions at source from employees' wages or salaries. For UK business owners, this system is not optional: the moment you employ anyone, including yourself as a director of your limited company, you become the collection agent for HMRC. You must deduct the correct tax and NI from each payment, report those deductions in real time, and remit the amounts to HMRC by the 22nd of the following month (or quarterly if your total monthly payments are below £1,500).
A common pitfall for small business owners is assuming that paying yourself only in dividends exempts you from PAYE entirely. It does not. A modest salary is often tax-efficient because it qualifies as a deductible business expense and builds your entitlement to the state pension. But if you have other employees, you must operate PAYE for them too, including subcontractors who fall inside IR35. The penalties for getting this wrong are not trivial: HMRC can issue fines of up to £3,000 per failure for late or incorrect RTI submissions, plus interest on unpaid tax and the risk of a full compliance check.
Here is how the mechanics work for a typical small business. You register as an employer with HMRC and set up a payroll system. Each pay period, you calculate gross pay, then deduct Income Tax using the tax code HMRC assigns (usually 1257L for 2025/26, which assumes the personal allowance of £12,570). You also deduct employee National Insurance at 8% on weekly earnings between £242 and £967, and 2% above £967. As the employer, you must pay employer National Insurance at 15% on earnings above the secondary threshold of £175 per week. These figures are reported to HMRC via Real Time Information submissions on or before each payday.
Consider a practical example. A construction subcontractor running a limited company pays himself a salary of £9,100 per year (just below the employee NI primary threshold). He takes the rest of his income as dividends. On that salary, his monthly pay is £758.33. He deducts no employee NI (earnings are below £242 per week) and no Income Tax (under the personal allowance). His company pays employer NI of 15% on the amount above £175 per week: that is roughly £91.67 per month, or £1,100 per year. The salary is a deductible business expense, saving corporation tax at 19% or 25%, so the net cost is modest. Meanwhile, he builds a qualifying year for state pension and keeps his payroll compliant.
What this means for you: PAYE is a fixed cost of having employees, not an optional extra. If you use an accountant or payroll software, confirm they handle RTI submissions and the monthly payment deadline. For most directors of small companies, a salary of around £9,100 per year combined with dividends remains the standard tax-efficient structure, but your specific situation may differ. Always take professional advice before setting your salary level.